Unhedged Hedge Funds

Brad Setser worries that many "hedge funds" will find that they have charged too little for selling insurance against volatility to other folks:

Roubini Global Economics (RGE) Monitor: I thought hedge funds were supposed to be hedged: Wasn't a key selling point of hedge funds that they could make money even when the (US) stock market was falling, unlike mutual funds?... I fully realize hedge funds do a whole lot of different things these days, and that in many ways the name "hedge fund" doesn't tell you much about what a hedge fund actually does.... Among my current worries: the temptation to make money (lots of it) by selling insurance against a more volatile world when volatility was falling may have been too great for some folks to resist. Paul McCulley:

With policy makers removing sources of volatility risk from markets, actual volatility falls, which like gravity, pulls risk premiums -- the market compensation for underwriting volatility -- lower. More specifically, P/Es rise, term premiums narrow, credit spreads tighten, and implied volatilities in options fall. As this process unfolds, the forward-looking return on risky assets falls, but their real time actual return is heady, as lower risk premiums are capitalized. This is a perfect prescription for bubbles.

Well said. The real time return -- not the forward looking compensation for taking risk -- may have come to dominate too many (financial) decisions. I am one of those curmudgeons who thinks a more unbalanced world will likely prove to be a more volatile world. We will see.